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The Impact of Oil Price on Supply Chain Strategies

David Simchi-LeviE-mail: dslevi@mit.edu

Professor, Massachusetts Institute of Technology

Chief Science Officer

ILOG

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Traditional Business Strategies

• Lean Manufacturing

• Outsourcing and offshoring

• JIT

• Quick and frequent deliveries

These strategies are based on assumptions of • Cheap oil price• Low labor cost in developing countries

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1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

US Logistics Costs as Percent of GDP

Increase in Logistics Costs

• Rising energy prices• Rail capacity pressure• Truck driver shortage• Security requirements

15% increase

3

0

200

400

600

800

1000

1200

1400

1600

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Total US Logistics Costs in $MMs

Inv Carrying Transportation Admin Total

Total US Logistics Costs 1984 to 2007 ($ Billions)

Source: 19th Annual Logistics Report 4

52%

Transportation

Admin

47%

62%

Total Cost

Inventory

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Impact of Oil Price on…

• Transportation Costs

• Network Strategies

• Transportation Strategies

• Supply Chain Strategies

US Diesel and Crude Oil Prices over time

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Relationship between Crude Oil price and Diesel Fuel Price

Trend Line Model

Diesel Retail Price(Cents per Gallon) = 2.38515*Crude Oil Price($/barrel) + 132.292

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Implications on crude oil price to transportation rates

• Given the relationship in the previous slide, we see that a $10/barrel increase in crude oil will result in ~$0.24/gallon increase in diesel fuel

• Standard fuel surcharge methodology is to increase surcharge $0.01/mile for every $0.06 increase in diesel fuel

• We conclude that for every $10 increase per barrel of crude oil price, we have an additional $0.04/mile increase in transportation rates.

Crude Oil ($/Barrel) 75 100 125 150 175 200TL ($/Mile) 1.65 1.75 1.85 1.95 2.05 2.15Increase (%) 0 6% 12% 18% 24% 30%

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Impact of Oil Price on…

• Transportation Costs

• Network Strategies

• Transportation Strategies

• Supply Chain Strategies

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Impact of Oil Price on Network Strategy

• Trading off oil price for… Inventory costs

Facility costs

Manufacturing costs

• Manufacturer of consumer packaged goods

• Manufacturing is possible in three locations:

Philadelphia- Highest production cost

Omaha-

Juarez, Mexico- Lowest production cost

• 60 potential DC locations

• 888 aggregated customers

• Inbound transportation uses commercial TL carriers

TL averages 40,000 lbs/shipment

• Outbound transportation uses a private fleet

Private fleet averages 20,000 lbs/shipment11

Case Study 1: Oil Prices and the Logistics Network

Case Study - Objectives

• Determine the best number and location of distribution centers, as well assignment of customers to DC’s.

• Determine the best allocation of production to their manufacturing locations.

• Understand how the optimal network would change as oil prices fluctuate Roughly 25% of the supply chain costs are in transportation

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Network Visualization

Discussion of Tradeoffs

• As crude oil price increases, transportation costs become more important relative to production, inventory and facility fixed costs.

• Oil price vs. inventory carrying and facility costs Additional DCs are more attractive

As outbound transportation becomes more expensive, it becomes increasing important to minimize the distance of the final leg.

• Oil price vs. production costs Production moves nearer to demand

Cheaper manufacturing in Mexico is offset by higher transportation costs.

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Oil price vs. inventory carrying and facility costs

Moving from $125/ barrel to $150/ barrel changes the optimal number of DC’s from 5 to 7. In particular, you can think of Las Vegas being replaced by Los Angeles, Albuquerque, and

Portland.$75/ barrel $200/ barrel

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The Tipping Point

Oil price vs. production costs

$75/ barrel $200/ barrel

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Total Cost Comparison

3% increase in total cost

as the price of a barrel

increases from $100 to $150

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Impact of Oil Price on…

• Transportation Costs

• Network Strategies

• Transportation Strategies

• Supply Chain Strategies

Changes in Transportation Strategy

• From JIT delivery to better utilization of transportation capacity Larger lot sizes shipped less frequently Efficient packaging to improve truck utilization

• From quick delivery to cheaper and sometimes slower transportation modes From air to ground From trucking to rail

• From dedicated to shared resources 3rd party carriers Consolidated warehouses

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Changes in transportation strategy: Examples

• In 2007, S.C. Johnson’ truck utilization project saved the firm “$1.6 million and cut fuel use by 168,000 gallons.” The firm found that mixing loads of Winded glass cleaner and

Ziploc bag, which used to be packed in separate loads, better utilizes truck capacity

• Multiple manufacturers store their products in ES3’ giant warehouse located in York Pennsylvania where truck loads are built and shipped to retailer’s distribution centers. An important benefit of the consolidated warehouse is

reduction in transportation costs

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Impact of Oil Price on…

• Transportation Costs

• Network Strategies

• Transportation Strategies

• Supply Chain Strategies

Changes in Supply Chain Strategy

• More Inventory Due to EOS and more DCs

• Emphasize on better service To reduce expediting costs

• Less offshoring To reduce total landed costs

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Sharp moves from offshoring to nearshoring

• TV manufacturer Sharp has recently started moving manufacturing facilities from Asia to Mexico to serve customers in North and South America.

• This is driven by the need to keep shipping costs low and time to market short. Indeed, price of flat TV typically falls fast and thus reducing

shipping time from about 40 days, when flat TVs were produced in Asia, to seven days makes a big impact on bottom line.

When to Move from Offshoring to Inshoring? -- Product Characteristics

III I

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Cost of Moving Infrastructure

L H

H

L

Transportation Impact

Inshoring

Manufacturing

or

Assembly

(TV, Refrigerators,

Appliances, Car

Parts, Furniture)

Inshoring

(Footwear, Toys)

Offshoring

(Mobile Phone, PC)

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Toy manufacturer is moving plants near demand

• Steiff, a privately owned German manufacturing company of toys was part of the global outsourcing trend when it moved around 20% of production to low cost countries. The objective was to cut cost and compete on price.

• Recently, this toy manufacturer started moving production back to Germany, Portugal and Tunisia. The reasons: quality problems together with high

transportation costs associated with manufacturing far from the key markets

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Drivers of Moving from Offshoring to Inshoring

• Oil Price

• Labor Cost

• The value of the dollar

Country Brazil China Malaysia Mexico USAverage Annual Wage Increase 21% 19% 8% 5% 3%

The Average Annual Wage Increase between 2003 and 2008

in different Countries

Mexico

US Production Cost per Unit

L H

H

L

Transportation Cost per Unit

(weight, volume, etc)

AsiaU

S

Slope= $ per pound

A

B

CSlope= $ per pound

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II

When to Move from Offshoring to Inshoring

Case Study 2: Sourcing Strategies

A large floor covering manufacturer

Hardwood, Ceramic Tile,

Carpet, Laminate

Challenge

Understand how increasing labor and transportation costs

across the globe are causing previous sourcing decisions to

be altered

Sourcing Parameters

37,000 SKUs

Large range of Production Costs $0.01 to $300 per unit if production is in the US

Large Range of Weights 0.01 to 5,000 pounds per unit

Manufacturing options US –Atlanta; Mexico – Monterey; China- Shanghai

Combination of transport modes Ocean; Rail; Truck Load

Sourcing Analysis - 2008

Mexico

US

China

Costs increase between 2003 & 2008

• Labor Costs US ↑ 15 % Mexico ↑ 23 % China ↑ 144 %

• Transportation Costs Ocean Freight ↑ 100 % TL/Rail ↑ 25 %

Good estimate of the increase in rail and TL costs Conservative estimate of the increase in ocean costs

Sourcing Strategies: 2003 and 2008

SKUs (in orange) moved from China

to Mexico

SKUs moved from China to US

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Your Turn!

How to contact me:

David Simchi-Levidslevi@mit.edu